Reducing withholdings by using double taxation agreements

Of course, moving your residence to a country where you do not pay taxes for your income is the first step, but according to your business model and the countries where your societies reside, sometimes it is not enough because we find ourselves in certain cases with withholdings on dividends.

Anyone who has a mercantile society should know what the withholdings are and how you can avoid them, so today we are going to dedicate an article to this topic.

For whom are withholding taxes important?

Not all companies have to deal with withholding on dividends. In fact, this type of withholding exlusively affects capital companies.

Personal companies and individual entrepreneurs (freelancers) are not affected by them because their companies do not form a separate legal entity and, therefore, can not distribute dividends. In such cases, the income is distributed proportionately among the members and taxed according to the types of income tax where they reside (our blog has more information on Limited Partnerships and others).

Thus, the withholding tax is the second most important tax factor in a capital company, after corporate or industrial tax.

Whether the withholding on dividends is applicable or not depends on the type of income and the jurisdiction in which the company is located.

In general, withholding tax is limited to three fairly broad categories of income: interest, dividends and royalty fees (royalties).

Dividends can be divided into direct dividends in the framework of large shareholdings in companies (in general, with shares of 5-10%) and stock dividends. The difference lies in the withholding tax applicable under the double taxation agreements.

As a general rule, large shares in companies have more advantages than smaller ones according to the double taxation agreements.

We have already written on the use of double taxation agreements for traders. In this article we will focus on the distribution of benefits via dividends for large shares (more than 5-10% and in some cases more than 25%).

Who has access to double taxation agreements?

As we have already mentioned, there are possibilities to reduce retention using the double taxation agreements. These agreements have several functions, but as the name suggests, they are designed to avoid having to pay taxes twice on the same income.

Given that withholdings are applied when the money comes in and also when it leaves a jurisdiction, we are faced with the possibility that depending on which countries the money goes through, it is subject to double or even triple taxation.

Double taxation agreements regulate which part of what type of tax each State should charge. In general, these agreements reduce the amount of the withholding so that the person only has to pay in their country of residence.

In the end, what is done is that either a tax credit is given (the tax or withholding already paid when collecting the tax in the country of residence is taken into account) or the person of withholding is exempted, so that they only have to pay the tax in their country of residence.

In any case, not everyone can resort to double taxation agreements. While it is true that individuals can use these agreements, they can only do so by proving their tax residence.

In other words, in order to make use of these agreements, the individual usually needs a certificate of tax residence, which is only issued after having resided in a country for six months (with a few exceptions, such as Cyprus).

This is done so that no one can take advantage of the double taxation agreements and obtain advantages that were not originally intended for them. Demanding a minimum stay of 183 days to receive the tax certificate ensures that each person can only use one of these agreements.

One detail that people often do not understand is that even without a tax certificate you may have to pay taxes (as a non-resident).

Being taxable in a country does not always mean you have to file a tax return there, and having a tax identification number does not necessarily mean you are taxable.

In the case of people without tax residence (perpetual tourists), you can not rely on any double taxation agreement; you at least cannot do it at a private level.

In these cases you can resort to the possibility of using the double taxation agreements from companies.

In this case, to be able to make these agreements, the company will have to have a commercial establishment in the country: that is, it must at least have some a economic substance (at least a small office and a worker).

Personal societies (LP, LLC, etc.) and self-employed people cannot make these agreements; at most, they could use them as individuals through their country of residence.

Of course, purely offshore companies without an office or local employees are excluded from the use of double taxation agreements.

Example: reduction of the withholding tax of a German limited liability company (GmbH)

Here, we have two examples to better understand the interaction between the withholding of dividends at source and the double taxation agreements.

Hans has a GmbH and emigrates to Panama. He pays the exit tax and is now convinced that after this procedure he will be able to forget the German Treasury forever, which will no longer charge taxes on his salary and dividends.

On Panama’s side, everything is working without problems. But Hans has not planned for the tax liability as a non-resident in Germany, the “beschränkte Steuerpflicht”. Nor has he taken into account the withholding tax on dividends (“Abgeltungsteuer”).

Before the dividends arrive, the GmbH will have to have withheld a good bit, neither more nor less than 26.3%.

Hans will not be able to avoid or reduce this retention, because there are two main problems in Panama.

First, as with other countries with low fiscal pressure, Panama does not have many double taxation agreements, in such a way that with Germany there are none (if Hans had his company in Mexico or Spain, he would have a double taxation agreement).

Secondly, although Hans has a fiscal obligation in Panama due to his permanent residence (only on the income obtained in the country), he can only obtain a tax certificate to use the double taxation agreements of Panama (among others, with Holland, Ireland, Portugal, United Kingdom, Mexico and Spain) after a minimum stay of 183 days.

So, after seeking legal advice in Librestado, Hans decides to go to Cyprus. Hans only has to spend 60 days in Cyprus to get a tax certificate, which seems acceptable to him.

Moving his fiscal residence to Cyprus from the beginning would have even saved him the exit tax (moratorium for staying in the EU) and in Cyprus it is not required to pay taxes on dividends, since it is registered as non-dom.

The double taxation agreement between Cyprus and Germany reduces the dividend withholding from 26.3% to 15%.

However, Hans still finds 15% to be too much, so what he does is sell his shares in the German GmbH to the Cypriot society he has set up to pay to get residency in Cyprus.

As a resident of Cyprus, as in Panama, you are not required to pay taxes on the sale of your shares.

Once it is the Cypriot company that has the shares of the GmbH, the European Union’s parent-subsidiary directive comes into play, according to which the benefits can be transferred to the parent company without any type of withholding. This, of course, would also have worked like that in Spain; moreover, the agreement between Spain and Cyprus directly reduces the withholdings on dividends to 0%.

To be able to enjoy these advantages in the EU, the related companies have to comply with certain requirements. The most important is that the parent company has a minimum of 5 to 10% of the shares in the subsidiary, a minimum holding period of 12 to 24 months is also required.

The example of Hans shows one of the many possibilities to optimize dividend withholding.

If you have interest in companies located in countries with a strong fiscal pressure, this subject is something to be taken into account.

Reducing witholdings by using double taxation agreements

The double taxation agreements come into play especially when a subsidiary or the parent company is based in a country outside the EU or the EEA, since in these cases we do not have the parent-subsidiary directive.

Let’s take as an example Hong Kong, a very popular location for companies.

If a German limited company (GmbH), to follow the previous example, acquires shares of a Hong Kong company, it will pay the dividend withholding in Germany at the time of the distribution of the profits.

On the other hand, Austria has signed a double taxation agreement with Hong Kong, so that the profit sharing of an Austrian limited company is taxed only 15% instead of 27%. This applies under the condition that the Hong Kong company has a real commercial establishment and does not operate as a mere offshore company.

Contrarily, if the subsidiary of which there is a substantial shareholding was in Singapore, Germany would be more appealing than Austria, with a tax of 0% compared to the 5% of the latter.

Austria, meanwhile, has 0% retention when the dividends come from various Arab countries such as Qatar and Bahrain, with which Germany has no agreement, in which cases the full tax is paid.

In the relationship between Germany and the United States, the situation is different. Here, we find ourselves with a retention rate of 30% in the US and 26.3% in Germany.

Even so, we do not have to pay 56.3% of taxes in this case, but under certain conditions thanks to the double taxation agreement, taxes fall to 5%, both in Germany and in Austria and Switzerland (the same would happen in Mexico; Spain would have to pay about 10% more).

Depending on the arrangement of countries, the double taxation agreement may be more or less favorable. And precisely one of the main tasks of the fiscal teams of international groups is to structure these arrangements in an optimal way, optimizing the internal compensations within the group of companies (Transfer Pricing).

Revenues should be taxed where the corporate tax is lower, and if they threaten a high retention at origin, they should be transferred to other countries to minimize them.

In some cases this may require more than two countries, as in the case of the “Double Irish Dutch Sandwich,” which was used by the media in connection with taxes from Apple and other US companies.

Of course, in case you wanted to copy their trick, remember that this is no longer possible (at least in Ireland in the form that it was done) since the EU has dealt with it.

Criteria for setting up mercantile companies

However, the entrepreneur on foot or even the self-employed can also take advantage of double taxation agreements for their benefit, as we have seen in Hans’ example.

In any case, every serious investor or entrepreneur should have a mercantile company, since with it he/she will be able to optimize in the long term his/her fiscal burden with regard to the withholdings on dividends in case of a change of residence.

In these mercantile societies the following points must be taken into account:

Null or low retention at origin

Ideally, the parent company will not have to make deductions either and can distribute the dividends free of taxes in cases involving adequate personal residence.

If taxes were needed to be paid on the dividends in the country of personal residence, a State would be sought for the company that would allow them to be kept at a minimum.

Double taxation agreement

In general, the existence of double taxation agreements must be assessed positively and does not entail disadvantages (if we do not take into account the exchange of information and mutual assistance between authorities).

However, the important thing here is not that there are many signed agreements, but that they are of good quality and that you can use them for your present and future business.

As this can not always be foreseen, there is a long-term possibility of optimizing the structure with intermediary holding companies, which give access to agreements different from those of the parent company.

EU directive on parent companies and subsidiaries

Above all, intermediary participation companies make sense within the European Union because they can take advantage of the aforementioned parent-subsidiary directive.

For this reason, it is generally recommended that the highest authority of the participation company be based in an EU country since, thanks to the directive on parent companies and subsidiaries, intermediate holdings from 30 other countries can be used optimally with their own double taxation

Holding regime

The majority of the most interesting sites to establish participation companies have a law that gives certain privileges to holding companies.

Broadly speaking, this means that shares can be sold tax-free and that dividends can be transferred with reduced (or exempt) taxes.

The possibility of selling the subsidiary company free of taxes is one of the central reasons for establishing a holding company in the case of many entrepreneurs and investors.

Low corporate tax

The holding does not have to be an operating company, but it can be.

Generally the holding companies can continue to take advantage of the holding regime even if they are used as operating companies to participate; there are very few countries in which this is not the case.

In spite of this, the usual thing to do is to have a holding that only deals with managing the other companies of the group and receiving the flow of money.

The holding company often bills affiliates for administrative tasks, transfers of intellectual rights or other services offered to its subsidiaries.

Of course, this should be done taking into account the usual prices in the market (transfer pricing) and it is important to be able to prove that everything is real and makes sense.

By billing the subsidiaries, benefits can be reduced in cases in which they pay high corporate taxes. The holding will then pay corporate taxes on the invoiced, taxes that if we have chosen correctly will either be null or very low.

Taxation of profits on the stock market and returns on capital

Given that the holding companies tend to be in charge of managing the assets of their subsidiaries, it is advisable to take into account how they pay taxes on capital yields.

In many countries, capital-based companies enjoy tax privileges in terms of wealth management benefits and do not pay (or pay very few) corporate taxes on capital yields.

CFC rules

The CFC rules (Controlled Foreign Companies) not only affect individuals, but above all capital companies.

These regulations limit the use of tax havens for tax optimization. It is at least intended to hinder the use of front companies, being able to take advantage of tax advantages only if they have a real establishment in the country of destination.

CFC rules mainly affect passive income (asset management and license fees).

Other aspects

There are many additional aspects to take into account when choosing the location of a holding company. But these are relevant especially for large groups, for example, the possibility of transferring losses, amortizations, etc.

Also, maintenance costs can be a factor to be taken into account, although the differences are small compared to the importance of the other points.

For the purposes of the typical Librestado reader, the six aspects discussed above are sufficient.

Now, only the last question remains: where should we establish the holding company?

There is no perfect location for the holding, but there are different countries that are especially suitable to be the headquarters of the parent company because they optimally meet the six aspects mentioned. These are jurisdictions in the EU without withholding tax.

Others, on the other hand, offer the possibility of creating useful intermediate holdings. In general, these are EU companies with withholding tax at the source or companies outside the EU, but with advantageous double taxation agreements.

Let’s take a more in depth look at it all.

The best jurisdictions for participation companies

Holding companies in Cyprus

Cyprus is reasonably one of the most popular options when choosing a location for the holding company.

Almost all of the Russians who invest in Europe, but also many other entrepreneurs, use holdings in Cyprus to optimize their investments in relation to withholding taxes.

At the end of the day, as an EU country Cyprus can take advantage of the directive on parent companies and subsidiaries, has signed many good double taxation agreements, has a low corporate tax of 12.5% (which is even easily optimized), there are many capital benefits that are not taxed (not counting forex and crypto) and it has a special holding regime.

Cyprus has CFC rules at the company level, but these can be easily avoided. In addition Cyprus does not apply withholdings, meaning that benefits can be distributed to any part of the world without paying taxes.

The holding company in Malta

Malta is also a frequent choice and essentially stands out for the same advantages as Cyprus. The corporate tax is lower, 5%, but it is associated with a tax refund procedure according to which 30% of the profits are blocked for at least several weeks.

Malta is generally more expensive than Cyprus and, from experience, it does not work as well.

Holdings in Estonia

Estonia and its E-Residendy is completely overrated for operating companies, but it is a very interesting option, although little known, for the holding companies.

It is little known because very few entrepreneurs know in detail the system of taxation of Estonian companies.

The 20% tax (which can be reduced to 14% if certain rules in the form of distribution of dividends are followed) is a deferred company tax and not a withholding tax. In Estonia the retention is 0%.

Since it is a corporate tax itself, it can not be reduced by the directive on parent companies and subsidiaries or with double taxation agreements, nor can it be computed in the country of residence of the partners.

The deferred income tax of the Estonian OÜ applies only when a profit obtained by the company through trade, services, license concessions or asset management has been distributed.

On the other hand, income that remains in society is not taxed whether it has been invested or reinvested.

Profit distributions from companies associated with the holding in Estonia do not count as operating income. That is, if a limited company in Estonia has a subsidiary in another company in the EU, in Spain for example, the company would pay its corporate tax in Spain (25%) but would not have to make any type of withholding thanks to the directive on parent companies and subsidiaries.

The profits would thus move to Estonia and from there flow directly to the individual with a 0% withholding tax at source, regardless of where the final partner resided.

Holding companies in Great Britain

The profits would thus move to Estonia and from there flow directly to the individual with a 0% withholding tax at source, regardless of where the final partner resided.

Before the inminent Brexit one must be very cautious while dealing with Great Britain. This country can still use the directive on parent companies and European subsidiaries, but we do not know what will happen next.

There are countries that are not in the EU which are still a part of this directive, such as Switzerland or Norway, but it is not known if the United Kingdom will follow the same path.

Taking into account the existence of other alternatives, I do not see the need to take the risk.

The Limited in England have an 18% corporation tax, they are not deducted at source and stand out above all because their registration is very cheap and fast.

Holding companies in Ireland

Ireland is a special case, but in many cases it may be worth it for a holding company.

This is a special case because the holding company is only appealing if it is planning to remain in the EU as a resident, since Ireland only distributes profits without withholding if the company’s headquarters or the partner’s residence is located in an EU country.

In addition, the administrator also has to reside in the EU; otherwise high additional costs arise to obtain an administrator liability insurance.

However, with 12.5% of corporation tax and some excellent double taxation agreements, especially with tax havens (for example, Panama), Ireland can be worthwhile in some cases.

Holding in Holland + Curaçao

In reality Holland is the perfect intermediate holding company, and in some ways the best transition to a final holding company.

The 15% retention at source in the distributions of dividends to individuals makes it less interesting, in spite of its other excellent qualities, which is why it should be used as an intermediate holding.

Fortunately there is a country outside the EU with a very favorable taxation that is very easy to combine with the Netherlands: its former colony, Curaçao, which is now an independent island in the Netherlands Antilles (ABC islands).

The double taxation agreement between Curaçao and the Netherlands stipulates that there will be no dividend withholding when they flow to residents in Curaçao (as long as minimum requirements are met, otherwise with a 5% withholding).

Especially in the long term, as the EU threatens with a retention in the punitive source for dividend distributions to tax havens, the Holland-Curaçao combination is a good option.

Intermediate holding and asset management

It is generally possible at the intermediate holding level to use a capital company from almost any jurisdiction. The important thing is that it matches well with the main portfolio company and gives access to the double taxation agreement that is needed. In general, the companies are valid both within and outside the European Union.

Depending on the market in which they are sold, intermediate holdings should be located in countries with a colonial past or with some other type of strong relationship.

Thus, France tends to have good agreements with French-speaking tax havens, Spain with Latin American tax havens, countries in Eastern Europe with former Soviet states, Dubai with the Middle East and Hong Kong with China.

For example, in the case of Mauritius, which has a mostly Indian population, it is not surprising that it has the best double taxation agreement available with India, an agreement that reduces the withholding tax to 5%, (however, of the 46 agreements signed by Mauritius, there are none with Ibero-American countries).

Even tax havens with a worse international reputation, such as Panama, offer interesting options according to the combination.

The most important thing is to make the right choice with the final holding company from which you will divide the final dividends. Intermediate holding companies can always be added in case of need, although for small entrepreneurs they will rarely deserve it if the only thing that they will achieve is avoiding a 5% retention (something that drastically changes with large sums).

Today’s article was not about heritage protection, but it should be mentioned here that the holding companies are also used for this purpose.

In general, it is preferable to have the holding companies in structures that protect your assets, such as foundations, associations or trusts. Of course, there are two problems here.

In the case of trusts and foundations it is possible within certain limits to give salaries and payments to oneself, as long as you are the beneficiary. However, especially in jurisdictions with heavy fiscal pressure and that are highly regulated, we have to give up practically all of the control.

On the other hand, as a beneficiary we obtain income, not dividends, and these are generally subject to higher taxation. In Cyprus, for example, only dividends are tax-free, whereas once the exempt amount of € 19,500 is exceeded, the income is taxable.

In the case of associations, if they are well structured you can have complete control but you can not distribute benefits, except for a salary. Furthermore, depending on the country in which you reside, you may not recognize the association as the real owner of the holding structure and others.

Of course, there are also solutions for the astute entrepreneur or investor. If you do not want to collect the money as a salary from the foundation or association, you can transfer it to another company that converts it into dividends.

That is, if both the foundation or association and the final recipient have an offshore company, the benefit can be moved between these companies that have no obligation to present any accounting.

In this case, money changes hands for bills issued from one company to the other. Thus, the offshore company owned by the final recipient can distribute dividends without withholdings or taxes.

And here we are today, introducing ourselves fully into the world of withholding on dividends and the options offered by the holding companies.

In case you want us to help you apply all this to your situation or you want to build the proper structure, you can book a consultation with us or write us.